Central WPI message is govt is key for inflation control
Though the market and the rupee were badly spooked by the inflation numbers, particularly the 80 bps revision in March WPI that suggests the 7.6% May WPI may just get revised, the numbers aren’t as dark as they immediately appear. What alarmed analysts is that the government has compounded the inflation problem with a sharp hike in support prices for crops. While this may be needed to ensure agriculture remains profitable, the 15-16% hike for paddy, 30% for pulses like urad, 35% for oils like groundnut and sunflower, and 40-50% for coarse grains like jowar and ragi is certain to put additional pressure on prices. If, and when, there is a fuel hike, this will aggravate matters—fuels have a 6.5% weight in the WPI. But keep in mind that core non-food manufacturing inflation has fallen from 8.4% in November 2011 to 4.8% in May 2012. At the same time, with food inflation back up at 10.74% for May as compared to -0.68% in January, its contribution to the overall hike in WPI is also up sharply—from -1.8% in January to 24.9% in May.
While demand-management, as evidenced by not cutting rates (or even hiking them as some have suggested!) helps keep even food inflation down in normal circumstances, the fact is that food prices are more determined by supply constraints. According to BNP Paribas, prices of fresh fruit and vegetables, that account for 26% of primary food prices (and therefore 3.8% of overall WPI) have surged 179% on an annualised basis in the three months to April—this, by the way, follows an annualised fall of 38% in the three months to January! This suggests the action required is less on RBI’s side, and more in terms of fixing various agriculture supply constraints—freeing up the agricultural mandis, allowing free movement of produce, bringing in large investments into cold chains (think FDI in retail!), and so on. To the extent the sharp hike in government consumption has resulted in increased demand pressure, this too is something RBI can do little about—almost all major inflation-control tools remain with the government.
But, and this is the next line of attack, while a rate-cut has the potential to raise demand pressures and trigger another inflationary spiral, there’s no guarantee that a rate cut will spur investments. If there is no coal linkage, how will a power plant come up? If power tariffs are not hiked and power losses continue to mount, how will a rate cut help? Similarly, availability of land, and not lower interest rates, is surely what will determine whether a Posco plant will come up. Obviously all of this is correct but those opposing rate cuts may be confusing necessary conditions with sufficient ones. A rate cut may not be sufficient enough to get new projects going if there is no land available, but at the margin it is necessary to make an unviable project viable, it improves India Inc’s bottom line and that, in turn, helps bring in more investors into existing firms. A very sharp rate cut may not be a great idea while inflation remains high, but RBI has to give a strong signal as to where rates are going.